PCAOB Reproposes Risk Assessment Standards; 75-Day Comment Period

Earlier today, the Public Company Accounting Oversight Board voted to repropose a suite of seven auditing standards relating to risk assessment and the auditor's response to risk, including risk of fraud. The reproposal includes changes made in response to comments received on the original proposal and other refinements. There will be a 75-day comment period, ending March 2, 2010.

[UPDATE: According to the PCAOB's press release: "the proposing release, text of the reproposed auditing standards, and related amendments to PCAOB standards will be available on the Web site under Rulemaking Docket No. 026. An archive of the Webcast and a podcast of the Open Board Meeting also will be available later today on the Web site at (http://www.pcaobus.org)/ Summarized below are some highlights of the reproposed rulemaking, based on my listening to the webcast of the open meeting. Reference should be made to the actual rule proposals, when they are posted on the PCAOB's website at the links noted above.]

Changes from Current Practice Outlined In Appendix 9
Associate Chief Auditor Keith Wilson explained that similar to the original proposal, an appendix will be included (Appendix 10) which compares the proposed standard to related International Standards on Auditing (ISAs), issued by the International Auditing and Assurance Standards Board (IAASB) and to related standards issued by the Auditing Standards Board (ASB) of the AICPA.

In response to a question from Chairman Dan Goelzer, and a related comment by Board Member Charlie Niemeier, Wilson noted that there is a separate appendix in the proposal (Appendix 9) which - although not a word by word comparison to existing standards - explains how the proposal would change current practice.

Business Risk, Fraud Risk
Board member Steve Harris said during the open meeting:

Risk taking is inherent in any business; therefore management should be able to identify, understand, and then mitigate those risks; the importance of understanding business risk … naturally flows over into audit risk… these standards more clearly articulate the auditors' responsibility to consider business risk as a very important element of audit risk."

Harris added: "The standards require the auditor to do the homework necessary to assess risk of error or fraud in the financial statements," and, "while [the auditor's risk assessment] do[es] not prevent poor decision making by management," the auditor's risk assessment is in the interest of investors." Also said Harris, "Another important improvement, is integration of, and emphasis on, the auditors' responsibility to consider the risk of fraud throughout the entire audit process... rather than approaching assessment of fraud risk as a [separate/standalone] exercise."

Materiality Definition Will Use Court Definition, Not FASB Definition
Among wording changes in the reproposal (vs. the original proposal) which Goelzer asked about is a change in how "materiality" is described. The reproposal uses the court's definition [TSC vs. Northway], Goelzer said, which focuses on whether an omitted fact would have a substantial likelihood of impacting the judgment of a reasonable person [investor], whereas the FASB Concepts Statement No. 2 definition of materiality (used in the original proposal) focused on whether it is probable that the magnitude of an item would have impacted the judgement of a reasonable person.

Asked by Goelzer why this change was made, Wilson responded:

"Two things caused us to change our approach: (1) FASB issued its Codification [in July], and did not include Concepts Statements, [which] causes one to conclude the Concepts Statement is not part of the [FASB's financial reporting] framework, and 2) the standard that applies for financial statements of public companies ... the court’s articulation of federal securities law, that is the standard that takes the day. As a practical matter, I think what FASB tried to do, was to have an accountant's description that parallels the court’s articulation of materiality. So, I think to the extent auditors have been thinking about materiality from the concept of a reasonable investor before, then they would have been thinking about both quantitative and qualitative factors."

The court definition, as pointed out by Goelzer, focuses on whether an omitted fact would have a substantial likelihood of impacting the judgment of a reasonable person [investor], whereas the FASB CON 2 definition focused on whether it is probable that the magnitude of an item would have impacted the judgement of a reasonable person.

Board member Steve Harris emphasized in earlier remarks:

these proposed standards give explicit direction to the auditor that the level of materiality should be based on quantitative and qualitative facts that would influence the judgment of the investor.

Chief Auditor Marty Baumann noted:

An important point here is we did not want to change practice, the fundamental definition is the one the court provides, [and that was] the most critical decision in making sure nothing changed."

Goelzer responded to Baumann: " That was the point I was hoping to bring out, we are not the ultimate [definers] of materiality," [vs. deferring/referring to the court's definition].

Another question relating to materiality, said Goelzer, was that the reproposal includes a lit of sixteen qualitative factors in making the judgment of whether something was material. He said: "The factors remaind me a little of SAB 99, but other things are not in SAB 99... like the costs of making the correction... and offsetting [effects of different misstatements].

Wilson responded:

Consistent with what Marty just said, we are retaining something we already have in existing auditing interpretations, not developing a new set of critera, trying to provide information [which appears] in existing standards, [because] based on comments [on the original proposal], it appeared auditors would like some additional factors, [we are] proposing to retain what we have now.

Baumann added:

Those factors were in the interim standards [note: 'interim standards' are the initial standards adopted on an interim basis by the PCAOB when it was first formed, based on existing standards of the AICPA ASB, pending further review by PCAOB]; we decided to carry those forward, [we are] not changing anything with respect to the definition of materiality.

Following the 75-day comment period on the reproposal, Goelzer noted: "I hope that depending on the nature of comments we receive, we will consider discussing with the SAG [PCAOB's Standing Advisory Group]," adding, "the next SAG meeting is next April, shortly after the comment period ends."

Conceptual Framework; Codification
A couple of broader issues were raised by board members at today's meeting, for future consideration. (1) Niemeier recommended the PCAOB focus on a conceptual framework, stating: "I have concerns that to date we haven’t adequately thought through how our standards relate to each other. (2) Goelzer asked about considering whether to Codify the PCAOB's standards, along with existing interim standards (anaologous to FASB's recent Codification). Baumann responded that in terms of priority, the standard-setting efforts were currently being directed at proposing new or amended standards that they believe would significantly improve audit quality, but that staff would consider issues around a potential Codification at a future date after the priority standard setting projects were completed; Goelzer agreed with this prioritization.

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